Opnext CEO Discusses F2Q2011 Results - Earnings Call Transcript

| About: Opnext, Inc. (OPXT)

Opnext Inc (NASDAQ:OPXT)

Q2 2011 Earnings Call

November 4, 2010 04:30 pm ET

Executives

Steve Pavlovich - Vice President of Investor Relations

Gilles Bouchard - President, Chief Executive Officer

Bob Nobile - Chief Financial Officer

Analysts

Sven Eenmaa - Thomas Weisel Partners

Dave Kang - B. Riley & Company

Raul Canmulkin - Jefferies & Company

Operator

Good afternoon. My name is [Rebecca] and I will be your conference operator today. At this time, I would like to welcome everyone to the Opnext, Incorporated Q2 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions).

I would now like to turn the call over to your host, Mr. Steve Pavlovich, Vice President of Investor Relations.

Steve Pavlovich

Thanks, [Rebecca]. Good afternoon and thank you for joining us. Today, we will discuss our financial results for the second fiscal quarter ended September 30, 2010. We’ll begin with Gilles Bouchard, our President and Chief Executive Officer, for an overview of the quarter followed by Bob Nobile, our Chief Financial Officer, who will provide additional detail on the financial results. Then Gilles will talk about market trends, operational plans and guidance and will follow with Q&A.

As a reminder, the matters we will be discussing today include forward-looking statements and as such are subject to the risks and uncertainties that may cause actual results to differ materially from those set forth in these statements. Such risks and uncertainties are discussed in the company’s filings with the SEC, including the press release filed today and our most recent annual report on Form 10-K, quarterly reports on Form 10-Q and any applicable amendments.

Please refer to the Safe Harbor language contained therein. In providing forward-looking statements the company expressly disclaims any obligation to update these statements.

Also let me mention that throughout this conference call, we will be referencing both GAAP and non-GAAP financial measures. A complete reconciliation of the non-GAAP financial measure to the applicable GAAP financial measure, including a reconciliation of adjusted EBITDA to EBITDA can be found in the press release we issued today, which is available on our Web site in the Investor Relations section.

With that, I will turn it over to Gilles.

Gilles Bouchard

Thank you, Steve, and good afternoon, everyone. Today we're reporting improved results for our second quarter ended September 30, 2010. Compared to the Jun quarter, revenues increased 9.5% to $86.4 million. 40G and above products grew 36% led by 40G and 100G modules as customers appear to be transitioning to higher speed products faster than we had previously expected. The industrial and commercial business trended another solid performance with 15% sequential growth.

Overall, demand was good. Backlog continued to grow and our book-to-bill ratio remained above one. But we continued to be supply constrained in a number of products. We are making progress towards profitability.

Gross margin improved by 275 basis points sequentially on a constant currency basis and operating expenses were essentially flat. However, weakness in the US dollar relative to the Yen continues to create significant headwinds for us. Bob will talk about this more in a moment.

Cash used in operations decreased from the June quarter as a result of our reduced loss and lower working capital requirements. As we prepare for continued growth we remain focused on both working capital management and progress toward profitability.

Now let me turn it over to Bob to discuss the financial results in more detail.

Bob Nobile

Thanks, Gilles, and good afternoon, everyone. We generated total revenue of $86.4 million representing an increase of approximately $7.5 million compared to the June quarter. Revenue from sales of our 10G and below products increased 1% to $56.5 million primarily as a result of increased sales of XFP modules.

40G and above revenues increased 36% to $22.2 million. This increase was driven by higher sales of 40G and 100G modules while sales of 40G subsystems were consistent with the last quarter. Revenue from industrial and commercial products increased 15% to $7.7 million representing the fifth consecutive quarter of INC growth.

Compared to the second quarter ended in September 2009 revenue increased $5.4 million from $81 million. Revenue from 10G and below products increased $6.6 million or 13.2% primarily as a result of increased XFP and SFP+ sales partially offset by decreased Xenpak and X2 revenues.

40G and above revenues decreased $5.8 million or 21% as an almost 85% decline in 40G subsystem sales was partially offset by higher 40G and 100G module sales. Revenue from sales on the industrial and commercial products increased $4.6 million or almost 150% from $3.1 million in the September 2009 quarter.

This quarter Alcatel-Lucent, Cisco and Huawei each represented 10% or more of total revenues. Combined, these three customers represented approximately 47% of total revenues compared to 51% in the June quarter.

Geographically, revenues in North America represented 30% of our total revenue while Europe represented 23%, Japan 14% and the rest of Asia was 25%. Gross margin was 20.4% compared to 18.8% in the June quarter while non-GAAP gross margin was 22.2% compared to 20.9% in the June quarter.

As compared to the June quarter, gross margin improved by 270 basis points at constant exchange rates and the favorable impacts from higher sales volumes, a higher mix of 40G and above revenues, lower per-unit average material and outsourcing costs and lower obsolete inventory and warranty charges more than offset the effects of lower average per-unit selling prices.

Gross margin was unfavorably impacted in the September quarter by a 140-basis point negative effect from foreign currency fluctuations.

Looking forward to our third fiscal quarter ending in December 2010, we expect our gross margin percentage to improve at constant exchange rates as we continue to benefit from improved volumes in product mix, although we are expecting a smaller improvement than the 270 basis points we enjoyed in the September quarter.

Including the effects of our hedging program, we experienced an effective average exchange rate of approximately JPY88 per US dollar for the quarter ended in September 2010. If the exchange rate remains at approximately JPY88 for the remainder of the December quarter we would realize an effective rate of approximately JPY82 after giving effect to our hedging program.

The JPY6 decrease from JPY88 to JPY82 results in about a 200 basis point adverse effect on gross margin likely more than offsetting the potential operational improvements I previously mentioned.

R&D expense was $16.5 million in the September quarter unchanged from the June quarter. Non-GAAP R&D expense increased slightly to $16 million from $15.8 million in the prior quarter and we expect non-GAAP R&D spending the quarter ending December 2010 to be in the $15 million to $16 million range as well.

SG&A expense was $14.1 million in the September quarter, slightly down from $14.3 million in the June quarter. Non-GAAP SG&A expense was $12.8 million this quarter, up $100,000 compared to June quarter. Looking forward to Q3, we expect SG&A expense to be slightly higher than the amount incurred in Q2.

Operating loss for the September quarter was $13.6 million compared to an operating loss of $16.2 million in the prior quarter. On a non-GAAP basis the operating loss was $9.8 million compared to $12 million in the prior quarter, a reduction of $2.2 million primarily due to higher gross margin.

Net loss was $14.4 million or negative $0.16 per fully diluted share compared to a net loss of $16.3 million or negative $0.18 in the June quarter. Non-GAAP net loss for the September quarter was $10.7 million or negative $0.12 per fully diluted share compared to $12.1 million or negative $0.13 in the June quarter.

EBITDA was negative $6.4 million compared to a negative $8.5 million in the June quarter while adjusted EBITDA was negative $4.4 million compared to negative $6.1 million in the June quarter.

Cash and cash equivalents decreased by $9.4 million and $97.5 million at September 30 reflecting $2.1 million of capital expenditures, $3 million of capital lease payments and $6.2 million of cash used in operations partially offset by a $1.9 million positive effect from foreign currency fluctuations.

Cash used in operations decreased from $19.7 million in the June quarter primarily as a result of lower working capital requirements. Looking forward to Q3, we expect our working capital to increase at a lower rate than our revenue growth as we continue to focus our efforts on improving our day sales outstanding and our inventory days on hand.

Our CapEx and capital lease obligations are expected to remain consistent with the September quarter. Looking beyond Q3 and consistent with our discussion last quarter, at constant exchange rates we expect gross margins to improve due to favorable product mix and cost reductions in several of our internally developed components.

In addition, we expect R&D spending to taper off as several advanced development programs transition to product introduction efforts. Based on these improvements, last quarter we talked about achieving break even adjusted EBITDA when revenues reached $90 million per quarter assuming JPY90 per US dollar.

Due to the continuing Yen appreciation we have adjusted our planning exchange rate to JPY80 per US dollar and, as a result, we now expect to achieve break even adjusted EBITDA when revenues exceed $97 million per quarter subject to product mix and the results of calendar year-end customer price negotiations.

Now, let me turn it back to Gilles.

Gilles Bouchard

Thank you, Bob. I'll start with the market. Recently published analyst reports reaffirm the trends we have been discussing in our recent earnings calls. The total optical component markets continue to grow at a healthy rate, about 16% CAGR over the next three years while the 10G and above transmission market, our sweet spots, should grow about 22% and the 40G and above market should grow almost 40%.

All of this is consistent with the demand trends that we're seeing from our customers. As I mentioned before, backlog increased again in September quarter and book-to-bill ratio was still above one.

Demand for 40G and 100G products has been particularly strong, exceeding our own expectations and appears to be the main growth engine for the future. While component supply has improved, we are still dealing with constraints that affect 10G, 40G and 100G revenues. We expect the supply situation to continue to improve during the second half of our fiscal year.

Last quarter I indicated that we had reached an [inflection] point in our ability to grow the top line. The 40G subsystem business, which had been a serious driver in revenues for the past year, had reached a point where it was no longer large enough to influence the overall result in a significant way. This is what played out in the September quarter. The subsystem business was flat yet total company revenues were up almost 10%.

With that as a background, let's take a deeper look at modules. The 10G and below business was flat this quarter. Supply constraints continue to be an issue and data com demand was softer than expected due to some customer inventory corrections.

We have begun to introduce several new products using in-house and uncooled laser technology and lower-cost optical sub assemblies. We expect that these products will have a favorable impact on revenues and margins going forward.

These new products are also contributing to increased design wins. During the third quarter we added 21 slots with eight different customers in 10G and below. Revenue growth in 40G and 100G modules was strong this quarter.

We believe the transition to higher speed products is accelerating. Much of our growth has been driven by major carrier deployments and upgrades across all regions of the world. New products have been driving design wins this year as well.

40G modules are now qualified in 68 slots across 27 customers, an increase of five slots. 100G CFP modules have been qualified in 10 slots with six customers. Our traditional industrial and commercial markets are healthy and new opportunities such as displays and printers have emerged.

Finally, our 100G coherent program continues to progress. As we mentioned last quarter, the market has split with some system vendors choosing a vertical integration strategy for their 100G modem IC technology.

Our focus has been to actively engage key DWDM system vendors on our 100G module approach. We believe based on those engagements that we have the potential to address about half the market. As such, we continue to see this as an exciting future opportunity for the company.

Now let's move to Q3 guidance. Driven by strong demand for 40G and above products, we expect our communication revenues to continue to grow in the December quarter while our industrial and commercial revenues are expected to be flat in Q3.

Therefore, we expect revenues to be between $87 million and $92 million for our third fiscal quarter and in December 31, 2010. So with that, I'll turn it back over to Steve for the Q&A portion of the call.

Question-and-Answer Session

Steve Pavlovich

[Rebecca], could you give the instructions for Q&A please?

Operator

(Operator Instructions). Your first question come from the line of Sven Eenmaa - Thomas Weisel Partners.

Sven Eenmaa - Thomas Weisel Partners

I wanted to ask in terms of the guidance, what is the expectation for the mix in communication side and in terms of 40G, 100G versus 10G and below in datacom and telecom?

Gilles Bouchard

We expect most of the growth in the guidance to come from 40G and above but we also expect some growth in the 10G markets and within the 10G markets, pretty similar growth between datacom and telecom.

Sven Eenmaa - Thomas Weisel Partners

So the correction, I guess you mentioned the correction in the inventory in datacom side, do you think that this just lasted for one quarter or is that completed?

Gilles Bouchard

Yes, we felt that mostly the summer and August and early September.

Sven Eenmaa - Thomas Weisel Partners

The other question is in terms of inventories, we saw I guess meaningful uptick in inventories since the last quarter. Could you give us little more color, what's behind that?

Bob Nobile

As Gilles mentioned earlier on, we've had some supply constraints on our products and as a result of that, trying to balance all the components for the finished goods winds up being difficult. So you wind up having most of your components on hand yet there are very small items which aren't there that allow you to finish the product.

Actually, quarter-over-quarter, although inventories grew in the aggregate, we did have a slight decrease in days on hand and our inventory turns improved slightly as well. So as I mentioned earlier, we expect our overall growth in capital requirements to increase next quarter but at a slower rate than our revenues, so we should start to see some improvements in that as we move through the rest of this year.

Sven Eenmaa - Thomas Weisel Partners

Just to clarify that, the sequential increase is primarily in raw materials and work in process, right?

Bob Nobile

Yes.

Steve Pavlovich

Next question, please.

Operator

Your next question comes from the line of Dave Kang - B. Riley & Company.

Dave Kang - B. Riley & Company

Apologize if you already went over this but I'm juggling a couple of calls, but did you go over your assumptions for your guidance? I heard your industrial being flat whereas comm did grow. Did you go over the mix between 10G below versus 40G and 100G, what your assumptions are there in the December quarter?

Gilles Bouchard

Yes, I just covered that, Dave, but to be clear I said the majority of the growth would come from 40G and above but we did expect to see some growth in 10G as well and the mix telecom, datacom would be about even and IC would be about flat.

Dave Kang - B. Riley & Company

Then I heard you talking about the inventory question with datacom side. But a couple of your competitors, they're more in the metro and long haul, even those guys talked about inventory question that's going on right now and I think that's why their guidance was kind of flat to down slightly where your guidance doesn't reflect that. Is that because you're more into 40G and 100G? Could you just talk about the overall optical component space in general?

Gilles Bouchard

Yes, I think what's happening is we're seeing very strong growth and continued strength on the (inaudible) side, especially in the higher speeds. I mean, 10G is behaving I'd say reasonably well but 40G and above is strong and even stronger than we expected.

So I think what's happening is, after talking to many analysts and customers our view is that the early recover of the market was heavily skewed towards infrastructure in passives as people really laid out the foundation for future networks and also by short reach components are led by the increase in the network traffic for the data centers.

I think we're moving to the next phase where people are starting to roll out the transmission gear and lighting in all this fiber and then doing it at a higher speed than we though. So I think to get a better return on investments that they put in infrastructure.

So that's kind of the big picture for us which means since we're not putting much in the passive and infrastructure and we didn’t see much of that growth earlier but we see very good strength right now especially in the higher speed part of the transmission market.

David Kang - B. Riley & Company

You said 10G was reasonable, what about below 10G, like 2.5 and below, how are they acting these days?

Gilles Bouchard

Well, it's a fairly small market for us. It actually grew for us last quarter, so it's behaving reasonably well for us. Again, it's a very small market.

David Kang - B. Riley & Company

What about in terms of geography? I guess most guys are pointing to China as a source of sweet spot, but others are saying it's kind of across the board including North America, as well as Europe. What do you see in terms of your markets as far as different regions are concerned?

Gilles Bouchard

If you look at our reasonable mix, if you go back a few quarters you'll see that the Asia Pacific has grown a lot. That's also due to the fact that we had very large business in Europe with NSN on subsystems which has gone down, so the share of Europe has done a lot for us.

But overall I'd say we see strength across the board, definitely a lot of strength in Asia and in China but we've seen good growth back in Japan, in the US and even in Europe, especially if we are looking at where 40G is being deployed now. It's a lot broader based than it has been the last couple years and we see deployments in established regions, in North America and China but as well in Japan in places like Brazil as well as in Europe.

David Kang - B. Riley & Company

Then your 40G cell system, the line card, is that going to come back at all because I'm hearing that could be on the way up again? But shall we be expecting -- or what kind of growth should we be expecting going forward, if any?

Gilles Bouchard

We definitely think that we're at the bottom right now. As you know it's a very low number and the recent trends and forecasts are somewhat optimistic in this market, so we think there's a good chance it will come back up for us. On the other hand, on the history we have to remain very cautious in this market, so we'll share the developments as they come along basically.

David Kang - B. Riley & Company

Last question is, I guess I don't know whether it was Isuppli or whoever, but I guess their take is that for 40G and 100G, both it'll look back to late 90s where OEMs did their own components, so they are expecting Cisco and Huawei to do their own 40G and 100G components. So what does that mean for merchant suppliers like yourself?

Gilles Bouchard

Well, it's a little bit different for 40 and 100. I mean, when 40 started most vendors had their own line cars or they were using subsystems [or] our subsystem where there was basically no merchant module market for 40G line sight in the early days of 40G.

As you can see from our growth, now the 40G line side market is starting to shift pretty heavily towards modules now and you see this trend continuing as either a lot of new commerce come in the market with modules or even some of the original players are introducing module-based products. So I think the module trend in 40G is well under its way as you can see in our numbers.

100G obviously nothing is really in the market right now. As I said in my prepared remarks, we believe based on what we hear from customers that we have accessed about 50% of the market with our module product, which by the way is much more than what happened in 40G historically, so we feel comfortable with that number. It would either be through customers who don't have their own technology and just start with modules right away.

But an interesting development is even some system vendors who are working or developing their own technology won't start with line car designs that can accommodate modules and are looking for second sources of those modules, so we have several conversations in that direction as well.

David Kang - B. Riley & Company

Can I ask you, I mean, can you categorize -- go over, I don't know if you can do that right now, but if you can just go over the major players like Cisco, Huawei, who has the -- who is vertically integrated in the 40G, 100G whereas other larger OEMs that are still relying on merchant players?

Gilles Bouchard

In 40G, and this is pretty well known, you have Ciena Nortel, Alcatel and Huawei in particular where they own line cars and the discrete base line cars. 100G I think in terms of what's been publically announced, you have Alcatel-Lucent and Ciena Nortel as well. Of course, Cisco through the acquisition of CoreOptics and Huawei has made several announcements on the various technologies they're investing in 100G.

Steve Pavlovich

Next question.

Operator

Your next question comes from the line of Bill Choi - Jefferies & Company.

Raul Canmulkin - Jefferies & Company

I actually wanted to clarify your gross margin guidance. You said that there will be operational improvements, [which has led to] 17 bp's from that, but currency headwinds could negate most of it, so just wanted to clarify that. So are you guiding a gross margin up or down sequentially?

Bob Nobile

As we said, our operational improvements will be something less than the 270 basis points we experienced this past quarter. But everything else being equal, just as a result of currency, we'll have a 200 basis point headwind. So you start from where we ended up this quarter, bring it down by 200 basis points and you bring it up by a percentage or so.

Raul Canmulkin - Jefferies & Company

But the thing is even the last quarter I remember you had used similar language but ultimately product mix appeared to have trumped the currency effects. So do you think something like that will happen again maybe next quarter depending on 40G and 100G mix?

Bob Nobile

Based on what we see now and the guidance that Gilles provided, our expectation is that it will not. But, again, we'll have to see how the quarter plays out.

Raul Canmulkin - Jefferies & Company

The other thing is, within your 40G and above business, do you give an account of 40G versus 100G, or give any color as to the size of your 100G business?

Bob Nobile

No, we do not.

Raul Canmulkin - Jefferies & Company

Could you just qualitatively talk about 100G opportunities, where you are seeing them, in particular geographically or customer-wise, any other color on that?

Gilles Bouchard

In terms of product shipments, right now 100G is limited to the 100G CFP which is a short-reach product, which is in the qualification stage with most customers, so we're seeing decent revenue but clearly this is a smaller revenue product for us and all of 40G by (inaudible) magnitude at least.

But this is a nicely very fast-growing product for us, again, that is still in qualification stage with most customers. On top of that we've had some contracts in 100G and other kind of revenues but, again, when we talk about 40G and above the vast majority is still 40G obviously.

Steve Pavlovich

Any other questions, [Rebecca]?

Operator

(Operator Instructions). You have no further questions at this time.

Steve Pavlovich

All right, great, thank you very much. [Rebecca], could you give them the replay instructions, please? If you don't have them there I can do it. Basically you can go on Opnext, our website, and go to the Investor Relations section and the replay will start in a few hours and will go for two weeks.

So with that, that concludes our Q2 conference call. Thanks, everyone, for joining us and we'll talk to you soon. Bye for now.

Operator

Thank you for participating. You may disconnect at this time.

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